If you’re an activist investor your job is to (1) think of an idea for how to make a company’s stock go up, (2) buy stock in the company, (3) convince them to do your idea, and (4) sell high. Step 3 tends to involve lots of attention-seeking – it’s easier to wear a company down into doing your idea if they’re constantly hearing about it from other shareholders and reporters and stuff – but steps 1 and 2, importantly, don’t.1 If you tell everyone about your great idea for Apple to issue GO-UPS,2 then they’ll all realize that Apple will certainly do it and unlock tens of billions of dollars of value, so they’ll bid up the stock before you can buy it and you’ll lose the opportunity to benefit from all those gains. That may be a bad example but just work with me here.
There’s another way of putting that, which is: if you secretly conceive of an idea to make Apple a better company, and then secretly buy up a bunch of Apple stock, and then announce to the world “surprise! I have 12% of Apple’s stock, and a brilliant idea that starts with a thematically appropriate lowercase i!,” and the stock goes up, and you make a lot of money – isn’t that unfair? You got to buy stock at the low, pre-publication-of-your-idea price; the people who sold to you were bamboozled into selling out too low because they didn’t know about your great idea. It almost “smacks of insider trading.”
Or something. I may not be doing this theory justice because I think it’s silly: that great idea is your idea; why shouldn’t you be able to make money off of it? (And why should anyone else?) The money is your incentive to come up with the idea in the first place, and do the hard ego-stroking work of pitching it to CNBC and the target company; if you had to share it with free-riders why would you take on the responsibility? We talked about this a little last year when there were vague rumors that the SEC was buying into it, and that they might require investors to disclose 5% stakes within 1 day of acquiring them (instead of the current 10 days), and include synthetic share ownership in computing the 5%, in order to make it harder for activists to secretly accumulate shares. I have not heard much about that proposal since, though I hesitate to assign any causality.
But last week in another, colder part of town, someone proposed the same thing. Canada, I mean. Canadian securities regulators proposed:
to provide greater transparency about significant holdings of issuers’ securities by proposing an early warning reporting threshold of 5% [and disclosure of a 5% stake no later than the opening of trading on the next business day], requiring disclosure of both increases and decreases in ownership of 2% or more of securities, and enhancing the content of the disclosure in the early warning news releases and reports required to be filed. We are also proposing changes so that certain “hidden ownership” [i.e. synthetic ownership3] and “empty voting” arrangements are disclosed.
Current Canadian rules require immediate disclosure of a 10% stake, versus U.S. rules requiring disclosure of a 5% stake within ten days (which in practice allows you to secretly buy quite a bit more than 5% before disclosing – Carl Icahn got to 13% before disclosing his Herbalife stake, though he couldn’t help himself from hinting at it beforehand), and neither U.S. nor Canadian rules currently require all derivatives to be included in that 5/10% calculation. So this would be rather a change.
Here’s the rationale:
- it may be possible for a shareholder at the 5% level to influence control of an issuer;
- significant shareholding is relevant for proxy-related matters (for example, under corporate legislation, a shareholder can generally requisition a shareholders’ meeting if it holds 5% of an issuer’s voting securities);
- market participants may be concerned about who has the ability to vote significant blocks as these can affect the outcome of control transactions, the constitution of the issuer’s board of directors and the approval of significant proposals or transactions;
- significant accumulations of securities may affect investment decisions;
- the identity and presence of an institutional shareholder may be material to some investors;
- a lower early warning reporting threshold will provide all market participants with greater information about significant shareholders and thereby enhance market transparency;
- a 5% threshold would be consistent with the standard of several major foreign jurisdictions; and
- changes in corporate governance practices have increased the need for issuers to communicate directly with beneficial owners. A lower threshold would provide reporting issuers greater visibility into their shareholder base and a greater ability to engage with significant shareholders earlier. It would also allow shareholders to communicate among themselves earlier.
I’ve bolded the ones that read particularly like “it’s unfair for activists to profit from their ideas and investments if everyone else doesn’t get an equal chance.”
So I mostly think that that idea is sort of irreducibly silly – people all the time make money by having ideas and don’t share with everyone else; Mark Zuckerberg didn’t even share with the guys who had the idea – but there’s also an empirical component to its silliness. The question is: if you’re just a passive guy who invests in a bunch of companies, would you rather
- have activists prowling around your stocks, sometimes pushing up the stock price in companies you own and benefiting you, other times buying you out before pushing up the stock price and leaving you feeling like a chump, or
- have “market transparency,” much less risk of selling out to an activist before he goes public, but also much less chance of activism in the stocks you own?4
I’m not aware of answers to that precise empirical question but the related question – “do activists actually improve performance in the stocks they target?” – has been asked fairly often, and the answers seem broadly positive. Like, “we find that targets of high frequency activist hedge funds – those that target ten or more firms between fund inception and 2005 – experience better long-term stock and operating performance,” or “abnormal return around the announcement of activism is approximately 7%, with no reversal during the subsequent year,” or “top performing activist-focused funds produced an average return 53.04 percentage points greater than that of the MSCI World Index between 2006 and 2011.” Also the Journal had an article this week about how activists have outperformed the hedge fund index over the last few years, though apparently not the S&P 500, so take that for what it’s worth.
All of which suggests that for the average investor the value of letting activists do stuff secretly might outweigh the value of transparency, though it’s not entirely clear. Here’s one more data point: the proposed Canadian rule changes probably are in part due to Bill Ackman’s proxy fight with Canadian Pacific, in which Ackman secretly accumulated 12.2% of the shares, some synthetically, before announcing his ownership. CP is up 95% since that announcement, making it not the most compelling advertisement for the evils of activist investing.
1. Nor does step 4, for that matter, unless your idea was “sell the company,” which it often is.
In 2012, Einhorn concluded his Sohn presentation by telling the audience that he’d invented something. It was a novel kind of preferred stock, he said, the characteristics of which could help certain companies unlock billions of dollars in value. He called his creation Greenlight Opportunistic Use of Preferreds, or—in case anyone missed his intent—GO-UPs.
Guys: it’s not a novel kind of preferred stock. It’s just the regular kind of preferred stock. The novelty would be convincing companies to do it.
3. Of interest only to me, probably, but the Canadians require disclosure of hidden ownership via an “equity equivalent derivative” like a total return swap or a contract for difference, but not a “partial-exposure instrument” like an option or a collar. What about Carl Icahn’s ~100% delta option trades? Well, the Canadians are aware of them, and “would generally consider a derivative to substantially replicate the economic consequences of ownership of a specified number of reference securities if a dealer or other market participant that took a short position on the derivative could substantially hedge its obligations under the derivative by holding 90% or more of the specified number of reference securities.” So it’s a delta test rather than a what-is-the-thing-called test.
Questions include: if you were an activist, would you be willing to buy 80%-delta cash-settled call options to beef up your stake secretly? Would you overpay for them? If you were a dealer, would you sell them? Would you overcharge for them? (Yes, right?) How would you hedge them? What vol would you use? Would you overhedge them? (That is, would you sell 80 delta call options and buy 90 deltas of stock figuring that, y’know, Carl Icahn announcing his position is gonna make the stock go up?) If you were a regulator what would you think about all that? Does it “smack of insider trading”? How would you know? What vol would you use? Show your work.
4. A further empirical question is: would this rule change significantly decrease activist investing in Canada? Again sort of unanswered empiricallyas far as I know; you could have a chain of reasoning that is like (1) reducing the stake you can accumulate secretly by 50% reduces your expected profits from activism by ~50% and (2) reducing expected profits from activism by ~50% should reduce expected quantity of activism by ~50%. I suspect both of those claims are exaggerated.